What is Hedge Fund?

Hedge funds are a type of private partnership investment, where many large investors pool their money together, and that money is managed and invested by a professional fund manager. It is a type of mutual fund whose main objective is to generate a good return for investors in all types of market conditions. Hedge means minimizing the risk and maximizing the returns on an asset by using different strategies. These may include strategies like short selling, leverage, futures and options trading.

Common people cannot invest in hedge funds. These funds are created keeping in mind the needs of high net worth people, for whose management and generating returns they are charged fees. They are also known as Private Equity Investment and Venture Capital Fund. In India, SEBI started hedge fund in 2012 as an AIF i.e. Alternative Investment Fund.

Features of Hedge Fund

Qualification: Hedge funds are available only to high net worth individuals who meet set income investment limits. To start a hedge fund, a minimum pool investment of Rs 20 crore is required. This is because hedge funds are considered a risky investment and only if the fund manager has sufficient funds available, he will be able to manage it well and cover the losses.

Active Management: Hedge funds are actively managed by the fund manager. That is, considering the market conditions and its ups and downs, he takes decisions quickly and changes his strategy so that good returns can be generated with less risk.

Fee Structure: A hedge fund charges investors a fee to manage it and generate returns. This fee can be performance based or percentage based, which is usually 2% or more.

Risk Management: Due to the aggressive nature of hedge funds, there is a lot of risk involved in them, and this is where the fund manager has to show his ability. They have to use various strategies to generate good returns, which along with boosting the returns, also increases the risk manifold.

Lock in period: Lock in period is imposed on hedge fund investments, which can be from 1 to 3 years. The investor cannot withdraw his money during this lock-in period. This is done so that the fund manager has capital available for a suitable time which he can use to invest in the market without any restrictions.
How does a hedge fund work?

The main objective of a fund manager in a hedge fund is to earn a good return for the investor, which can beat the average returns of the index and other investment options. For this, he researches the market and selects the appropriate strategy and portfolio. All these include the following steps:

Fund raising: First, interested high net worth investors create a capital pool by contributing their money. Fund managers use this capital pool for investment and trading.

Investment: The fund manager uses the collected pool investment in different strategies for trading and investing in the stock market. Investment strategies may include short selling, derivatives, buying undervalued stocks, etc.

Risk Management and Objective Achievement: While using any kind of investment strategy, the fund manager has to manage the risk well so that adverse market conditions do not have much impact on the portfolio. For this, he can take the help of diversification, in which he can divide the portfolio into different asset classes or can also take the help of derivatives i.e. options and futures.

Types of Hedge Fund

Global Macro Hedge Funds: As the name suggests, these funds are not limited to India only but invest as per global trends. In such hedge funds, managers use appropriate strategies keeping in mind the changes in the financial sector in view of global economic activities. It is not limited to just equities but also invests in bonds, commodities and currency etc.

Activist Hedge Funds: Activist hedge funds are known for their unique working. They invest in a company for so much stake where they can participate in the management and operation of the company. In this way, it can give suggestions to the management of a company as to why the company’s growth is being affected or not. If the decisions taken as a result of these suggestions improve the management of the company, then the profitability resulting from this becomes the reason for the increase in its stock. Being a large shareholder, the hedge fund also profits and can exit by selling its stake once its objective is achieved.

Equity Hedge Funds: Equity hedge funds invest in global and domestic stock markets, where they focus on undervalued stocks by selling overvalued stocks.

Relative Value Hedge Funds: Relative value hedge funds try to earn profits by taking advantage of the difference in prices of one or more financial instruments. For example, fund managers can long the stock of one company and short the other. In this way, he tries to earn profit in any kind of market condition by reducing his risk.

Hedge funds are professionally managed funds, which offer high returns. It works according to the risk profile of a select few people. Hedge funds in India are mainly used by big investors whose net worth is at least Rs 1 crore. These investors have their own investment needs which they want to manage as per their risk profile.

The second main investor class that invests in hedge funds is institutional investors. These investors include insurance companies, banks, and pension funds etc., who have to pay interest on people’s money lying with them.

Apart from this, hedge funds are suitable options for family offices and seasonal investors who have good knowledge of the market and understand the ups and downs in the market well.

Benefits of Hedge Fund – Benefits of Hedge Fund

Higher Returns: Although hedge fund investment is also not free from loss and risk, the returns obtained in it are quite good as compared to other means of investment. In this, the fund manager tries to generate maximum returns by using different strategies according to the market conditions.

Professional Management: Hedge funds are managed by professional fund managers. These are experienced people registered by SEBI who charge some fees for their professional services. Since the management of investment money is in the hands of these people, they do not need to worry much about their money.

Diversification: Hedge fund managers do not invest in any one investment vehicle. To diversify the portfolio and reduce risk, investments are divided into different assets such as bonds, stocks, commodities and currency etc., due to which if even one sector does not perform, the overall portfolio is not affected much.

Investor Centric: Hedge funds are designed keeping in mind the interests of some high net worth individuals, institutional investors, banks and commercial firms. Managers operate these funds according to the needs and risk appetite of these investors.
Disadvantages of Hedge Fund – Hedge Fund ke disadvantages

High Minimum Investment: Investment in hedge funds in India is done only by high net worth people, who have their own separate investment requirements. The minimum amount to invest in these starts from Rs 1 crore, hence it is not possible for a common investor to avail the benefits of these services.

Lack of liquidity: Hedge funds have a lock-in period of 1 to 3 years. Due to this lock-in period, there is a lack of liquid in the hedge fund, which means that in case of any emergency, investors are not able to encash their money. However, this is also important from the investment manager’s point of view, hence it is very important to keep this aspect in mind before investing in a hedge fund.

Complex Strategy: Managers use complex strategies for investment of hedge funds, which include hedging, short selling, leverage and derivatives etc. Although this helps in increasing the returns of investment, but also increases its risk to a great extent.

Charges: In return for the management of the hedge fund, the manager charges a fixed or profit percentage.
Taxation on Hedge Fund – Hedge Fund par taxation

Hedge funds fall under Category III AIFs, in which tax is payable on any profits made by the fund. Taxation on hedge funds applies as detailed below:

On profits less than Rs 5 crore: 30%

On profit more than Rs 5 crore: 42.74%

On Dividend: 15%

Conclusion

Hedge funds are an excellent investment option for a select class of investors. These are designed keeping in mind their personal investment needs, which include many features like higher minimum investment, diversified portfolio, risk profile etc. This is important for those people who need an option other than the traditional method to meet their investment needs.